Complexity and Contract - article ; n°1 ; vol.92, pg 149-178

W. Bentleymacleod

Description

Revue d'économie industrielle - Année 2000 - Volume 92 - Numéro 1 - Pages 149-178
It is well known that contract incompleteness can arise from the impossibility of planning for all future contingencies in a relationship (e.g. Williamson (1975)). In this paper it is shown that whether or not such incompleteness constrains the efficiency of the contract is very sensitive to assumptions concerning the timing of the resolution of uncertainty. It is shown that when agents must respond to an unforeseen contingency before being able to renegotiate the contract, then contract complexity is a binding constraint, a case that is called ex post hold-up. Secondly, it is suggested that the amount of multitasking can provide a measure of contract complexity. When complexity is low, contingent contracting is efficient, while subjective performance evaluation is more efficient when complexity is high. In this case the optimal contract for ex post hold-up is based upon the ability of humans to make subjective judgments that are in some cases more informative than explicit performance measures. Moreover, the efficiency of the contract is not sensitive to human errorperse, but is an increasing function of the correlation in judgments between the contracting parties.
Il est communément admis que l'incomplétude des contrats peut provenir de l'impossibilité de se préparer à toutes les contingences futures d'une relation contractuelle (cf. Williamson 1975). Dans ce papier, nous montrons que le fait qu'une telle incomplétude contraigne, ou non, l'efficacité contractuelle est très dépendant des hypothèses concernant le processus de traitement de l'incertitude. Nous montrons que, quand les agents doivent répondre à une contingence imprévue avant d'être capables de renégocier le contrat, la complexité contractuelle est alors une contrainte sans issue. Ce cas est celui du hold up ex post. Deuxièmement, il est suggéré que l'importance des activités multi-tâches peut constituer une mesure de la complexité contractuelle. Quand la complexité est faible, un contrat contingent est efficace. Alors qu'une évaluation subjective des performances des contractants est plus efficace quand la complexité est élevée. Dans ce dernier cas, le contrat optimal pour prévenir le hold up ex post est fondé sur l'aptitude des êtres humains à produire des jugements subjectifs qui sont dans certains cas plus appropriés que des mesures explicites des performances. De plus, l'efficacité du contrat n'est pas sensible à l'erreur humaine en elle-même, mais est une fonction croissante de la corrélation des jugements entre les parties contractantes.
30 pages
Source : Persée ; Ministère de la jeunesse, de l’éducation nationale et de la recherche, Direction de l’enseignement supérieur, Sous-direction des bibliothèques et de la documentation.

Informations

• Publié par: REVUE_D-ECONOMIE_INDUSTRIELLE
• Publié le: 01 janvier 2000
• Nombre de lectures: 11
• Langue: English
• Poids de l'ouvrage: 2 Mo

Extrait

W. Bentley Macleod
Complexity and Contract
In: Revue d'économie industrielle. Vol. 92. 2e et 3eme trimestres 2000. pp. 149-178.
Citer ce document / Cite this document :
Macleod W. Bentley. Complexity and Contract. In: Revue d'économie industrielle. Vol. 92. 2e et 3eme trimestres 2000. pp. 149-
178.
doi : 10.3406/rei.2000.1044
http://www.persee.fr/web/revues/home/prescript/article/rei_0154-3229_2000_num_92_1_1044Abstract
It is well known that contract incompleteness can arise from the impossibility of planning for all future
contingencies in a relationship (e.g. Williamson (1975)). In this paper it is shown that whether or not
such incompleteness constrains the efficiency of the contract is very sensitive to assumptions
concerning the timing of the resolution of uncertainty. It is shown that when agents must respond to an
unforeseen contingency before being able to renegotiate the contract, then contract complexity is a
binding constraint, a case that is called ex post hold-up. Secondly, it is suggested that the amount of
multitasking can provide a measure of contract complexity. When complexity is low, contingent
contracting is efficient, while subjective performance evaluation is more efficient when complexity is
high. In this case the optimal contract for ex post hold-up is based upon the ability of humans to make
subjective judgments that are in some cases more informative than explicit performance measures.
Moreover, the efficiency of the contract is not sensitive to human errorperse, but is an increasing
function of the correlation in judgments between the contracting parties.
Résumé
Il est communément admis que l'incomplétude des contrats peut provenir de l'impossibilité de se
préparer à toutes les contingences futures d'une relation contractuelle (cf. Williamson 1975). Dans ce
papier, nous montrons que le fait qu'une telle incomplétude contraigne, ou non, l'efficacité contractuelle
est très dépendant des hypothèses concernant le processus de traitement de l'incertitude. Nous
montrons que, quand les agents doivent répondre à une contingence imprévue avant d'être capables de
renégocier le contrat, la complexité contractuelle est alors une contrainte sans issue. Ce cas est celui
du "hold up ex post". Deuxièmement, il est suggéré que l'importance des activités multi-tâches peut
constituer une mesure de la complexité contractuelle. Quand la complexité est faible, un contrat
contingent est efficace. Alors qu'une évaluation subjective des performances des contractants est plus
efficace quand la complexité est élevée. Dans ce dernier cas, le contrat optimal pour prévenir le hold up
ex post est fondé sur l'aptitude des êtres humains à produire des jugements subjectifs qui sont dans
certains cas plus appropriés que des mesures explicites des performances. De plus, l'efficacité du
contrat n'est pas sensible à l'erreur humaine en elle-même, mais est une fonction croissante de la
corrélation des jugements entre les parties contractantes.Bentley MacLEOD* W.
COMPLEXITY AND CONTRACT
Mots-clés : Contrat, incitation, rationalité limitée.
Key words : Contract, Incentives, Bouned rationality.
« The time is not here yet, but I hope it is coming when judges
realize that the people who draft... contracts cannot envisage all
the things that the future will bring » (1).
I. _ INTRODUCTION
Building upon the work of Simon (1957), Williamson (1975) observes that
a fundamental reason for transaction costs is the impossibility of planning for
all future contingencies in a relationship (2). The purpose of this paper is
explore the conditions under which such complexity can constrain the set of
feasible contracts, and help us better understand the contracts observed in
practice. Specifically, situations where agents are asked to make decisions
when unforeseen events occur, but cannot renegotiate the contract is one I call
ex post hold-up. In these cases, complexity can have an important impact upon
the form of the optimal contract. The paper begins by comparing the structure
(*) I very much appreciate the comments of the referees, Olivier Williamson and Sherwin
Rosen on this work, as well as seminar participants at the University of California Davis,
Stockholm School of Economics, University of Oslo, of Bergen, and the Yale
Law School. I am also grateful to Mehdi Farsi for able research assistance. The financial
support of National Science Foundation grant SBR-9709333 is gratefully acknowledged.
(1) A. Denning, « The Discipline of Law 56 » (1979). As quoted in Farbsworth (1990), page 543.
(2) In particular the discussion in section 2.1 of Williamson (1975).
REVUE D'ÉCONOMIE INDUSTRIELLE — n° 92, 2e et 3e trimestres 2000 1 49 of the ex post hold-up problem to other contracting problems in the literature
and suggests that a key ingredient in understanding the form of the optimal
contract is the timing of information and actions in a relationship. Secondly, a
way to measure contract complexity is suggested that has empirical implicat
ions. Finally, the optimal governance of contracts facing ex post holdup when
complexity is high depends upon the superior pattern recognition abilities of
humans. In this case the optimal contract depends upon the degree of correla
tion in beliefs between the contracting parties.
Beginning Simon (1951), there is a large literature that takes as given
contract incompleteness due to transaction costs and then explores the impli
cations of this for efficient governance. Simon argues that giving one agent
authority over another economizes on transaction costs by allowing one to
delay decision making until after uncertainty has been resolved. In a similar
vein, the recent property rights literature, beginning with Grossman and Hart
(1986), argues that problems of contract incompleteness are resolved by an
appropriate reallocation of bargaining power in a relationship through owners
hip rights. Agency theory, beginning with Ross (1973), Mirrlees (1999) and
Holmström (1979), focuses upon how asymmetric information can explain
observed contracting arrangements. Holmström and Milgrom (1991) show
that in an multi-tasking context when signals concerning one task are not avai
lable, then the optimal contract may ignore information regarding performan
ce on other tasks.
While contract incompleteness and asymmetric information are central
theme in this literature, the role of human cognition is not. One reason, as
observed by Oliver Hart (1990), is both agency theory and the property rights
literature assume that agents select their actions immediately after the contract
is signed. The contract is designed to provide the appropriate incentives for
performance at this stage, and hence if ex post unanticipated events occur these
cannot affect actions that are sunk. In other words, there is no role for antici
pated events in the structuring of the optimal contract. Agents may anticipate
events that cannot be described ex ante, but this is a different problem, and one
for which Maskin and Tiróle (1999b) demonstrate that under the appropriate
conditions does not affect the ability of individuals to optimally regulate their
relationship.
How then do we reconcile these results in contract theory demonstrating the
irrelevance of human cognition for contract formation with Williamson
(1985)'s view that bounded rationality is central to the theory of transaction
costs (3) ? My first point is that we can usefully categorize different contrac-
(3) See chapter 1.
1 50 REVUE D'ÉCONOMIE INDUSTRIELLE — n° 92, 2e et 3e trimestres 2000 problems as a function of when information is revealed. In the next secting
tion the sequence of moves for the agency model, the hold-up model and
Simon's authority model are reviewed. While these are important classes of
problems that correspond to many interesting contracting situations, there are
not all inclusive. In many principal-agent situations the agent is called upon to
respond to unexpected events in a way that is personally costly, but for which
there is not sufficient time to renegotiate the outstanding contract with the
principal. I call this contracting hazard ex post hold-up, and show in section 3
that the nature of human cognition may play an important role in the optimal
regulation of the relationship.
Many employment relationships have exactly this characteristic. For
example, fireman may have to respond quickly to events while a building is
burning, and cannot renegotiate the contract with the city in mid-blaze.
Emergency room doctors must deal with a variety of unexpected events, some
of which are dangerous to the physician, especially when the patient has a
communicable disease. In these situations hold-up can take one of two forms.
First the agent after taking an action may not receive the compensation that he
or she feels is appropriate. Secondly, the principal may worry that the agent
may not have the correct incentives to take the appropriate action ex post.
Section 3 continues with a di